How Do I Know if I Have an IRS Form 3520/3520-A Filing Obligation?

Interests in or transactions with foreign trusts can cause headaches for federal income tax purposes.  Depending on the interest or transactions at issue, U.S. citizens or residents may have to file a Form 3520, a Form 3520-A, or both each and every single tax year.  And the failure to file either form when required can (and often does) result in significant civil penalties.

But, commonsensically, these civil penalties only apply if the entity in question is a “foreign trust”—which begs two questions:  (1) what is a “trust”; and (2) when is it “foreign”?  The Fifth Circuit’s recent decision in Rost v. U.S., No. 21-51064 (5th Cir. Aug. 11, 2022) provides some insight on these two questions and is discussed more fully below.

IRS Form 3520 and Form 3520-A Civil Penalties. 

Prior to any discussion of Rost, it is important to understand what was at stake in that case:  civil penalties.  As indicated above, federal tax law requires the disclosure of foreign trusts.  Under section 6048(a), a “United States person” must report “the creation of any foreign trust” and “the transfer of any money or property (directly or indirectly) to a foreign trust.”[i]  For these purposes, a “United States person” includes U.S. citizens and residents.[ii]  These disclosures are required on IRS Form 3520.  If a U.S. person has an IRS Form 3520 filing obligation and fails to timely file a Form 3520, the IRS can impose a “penalty equal to the grater of $10,000 or 35 percent of the gross reportable amount.”[iii] Generally, the “gross reportable amount” is the amount that should have been disclosed—e.g., the amount of funds transferred to the foreign trust.

Federal law also requires the disclosure of certain ownership in foreign trusts.  Under section 6048(b), anyone treated as the owner of a foreign trust under the grantor trust rules must ensure that the foreign trust annually files a Form 3520-A with the IRS.  If the foreign trust fails to file a Form 3520-A (which can be common), the grantor must file a substitute Form 3520-A with the IRS.  If a U.S. person has an IRS Form 3520-A filing obligation and fails to timely file a Form 3520-A, the IRS may impose “a penalty equal to the greater of $10,000 or 5% of the gross reportable amount.”[iv]  In these instances, the “gross reportable amount” is “the gross value of the portion of the trust’s assets at the close of the year treated as owned by the United States person.”[v]

The Facts of Rost.

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